Limit these Buybacks

SEVERAL blue chips are in danger of disappearing from our stock markets. Several foreign companies want to buy back all outstanding shares and delist themselves.

These include Cadbury, Carrier, Wartsila, Hoganas, Cabot India, and ITW Signode. The government needs to stop this forthwith. The public loss from delisting so greatly outweighs the private gain of the delisters that we need a ceiling on buybacks, leaving at least 15 per cent of outstanding shares in the market.

We must avoid a situation where the best companies exit from the stock market, leaving only the scum behind. I say this as a libertarian who generally regards such rules as wooden and misconceived.

If blue chips exit altogether, investors and stock exchanges will be the poorer for it. This is not just a private matter between shareholders and promoters.

If blue chips exit, the market capitalisation of our stock exchanges will go down, liquidity will go down, and so the overall capital market will suffer.

The quality of our listed companies is dodgy at best, and few companies boast good governance. If they exit, the worsening capital market will hit the whole corporate sector.

Not so long ago, buybacks were prohibited altogether. I then strongly argued in favour of buybacks subject to safeguards, something the government ultimately implemented.

Why? Because buybacks serve a definite market function the world over. Unconditional buybacks can lead to rampant insider trading. But if companies have to extinguish shares that are bought back, as is the case in India, insider trading is rendered difficult.

When shares are extinguished, this reduces the outstanding number of shares of a company, raising earnings and assets per share, and so driving up the market price.

A buyback is a legitimate way for a company to reward shareholders by pushing up the price. Again, if a company’s equity is diluted by stock options, reducing earnings per share and hence the market price, a buyback can remedy the damage.

In the West, a company with large cash reserves becomes a target for takeovers. This is why Western companies use cash reserves for buybacks. It is a legitimate defence against possible takeovers.

How relevant is all this for India? I think we should allow buybacks subject to a limit: at least 15 per cent of a company’s shares must remain in the market.

This will give flexibility to managements, yet ensure that blue chips do not disappear altogether. If only 15 per cent of a company’s shares are outstanding, it is safe from a hostile takeover.

This rule should apply to all listed companies, Indian or foreign. What about foreigners who come in with 100 per cent equity? As a rule, they should be asked to divest 24 per cent of their holding to the Indian public within ten years.

Critics may object that I, of all people, want to bring back the neta babu raj. In fact I argued the case for this regulation several times in the early 1990s, on open economy principles.

Indian import duties provide a monopolistic windfall to foreign companies investing in India. There is a case for keeping part of this windfall in India through a minimum Indian ownership.

Second, companies pay duty on most imported components but not on the most important component of all — their brand names. These are far more valuable than raw materials, yet escape tariffs and yield one more unwarranted windfall.

In practice, the windfalls may be eroded by overcapacity and intense competition between foreign companies. Coke and Pepsi have suffered big losses. Still, the implicit windfalls exist, and these companies would have lost even more had they been paying import duty on brand names.

Some companies may enter India to serve the global market, not to make windfalls in the local market.

If a company exports over one-third of its output, we should regard its operations as global, and such a company should be exempted from disinvesting to the Indian public.

But all other foreign companies should be asked to disinvest 24 per cent of equity within ten years. This will give them absolute control, yet enable Indians to share their windfall gains. That bait of 100 per cent equity will also encourage companies to use India as a global export platform.

Will this rule inhibit foreign direct investment? Very little or not at all. Many countries, including China, have from time to time imposed limits on foreign equity, yet received huge inflows.

Indonesia under Suharto required foreigners to disinvest 51 per cent of equity within 20 years, yet received far more FDI than India does today.

Even more important than the economic dimension is the non-economic one. It is socially desirable to spread share ownership over as many people as possible, more so in the case of foreign companies.

This reduces social antagonism between Indians and foreigners, between producers and consumers. The transgressions of Reliance attract less social opprobrium because the Ambanis are perceived as having shared their loot with four million Indian shareholders.

A time may come when the Indian market is so wide and deep that it does not matter whether blue chips exit or not. A time may come when our import duties fall to such low levels that no significant windfalls accrue to foreign investors.

When we get to that stage, there will be an economic case for allowing blue chips to exit, though the social case will remain. But we are a long way from that stage. Our capital markets are still nascent and fragile. Let us not endanger them through unlimited buybacks.